Contrarian Bet: Turnaround in The Chemical Industry

Once touted as Top Gainers during the corona virus pandemic period, chemical stocks now face a prolonged downturn, offering reduced valuations that attract investors. Mandar Wagh delves into the industry’s downturn, current financial performance and future prospects to assess if investing in these stocks as a contrarian bet is wise. 

A majority of individuals demonstrate a high adaptability to the ‘go with the flow’ mindset, showcasing a shared psychological inclination to conform to prevailing trends in their surroundings. This can manifest in various aspects, such as adopting the latest fashion styles, engaging with trending content on social media, or even mirroring the investment sentiments of the majority in financial markets. This collective sentiment often results in significant buying or selling activities, driven by the prevailing optimism or pessimism surrounding a particular stock or sector, as the majority of investors tend to align their actions with the same sentiment. [EasyDNNnews:PaidContentStart]

However, just as in life, there are rebels in the market who employ the ‘contrarian strategy’ in investing. This approach involves deliberately going against the current market trend, opting to sell when others are buying and buying when the majority is selling. These contrarian investors seek opportunities during moments when the market sentiment diverges from the perceived reality, aiming to capitalise on potential reversals or undervalued assets that others may overlook. For example, numerous investors perceived IT stocks as favourable contrarian opportunities and initiated investments based on their individual risk appetites. Recently, there has been a shift in fortune for IT stocks as global recessionary concerns have eased. 

Also, investors regained confidence in the sector following a significant correction that made IT stocks available at discounted prices. IT stocks witnessed a robust rally driven by heightened optimism stemming from the Federal Reserve signalling interest rate cuts in 2024 and ongoing collaborations between domestic industry leaders and global IT majors to develop AI solutions, which have the potential to transform the industry. When assessing potential contrarian investment opportunities, the chemicals industry swiftly emerges as an industry facing notable headwinds. Let’s examine whether the chemical industry is on the brink of a potential turnaround by analysing the financial performances of industry leaders, as well as assessing domestic and global risks factors and growth triggers.
 

Chemical Industry Overview

The Indian chemical industry holds substantial economic importance for the country, encompassing key segments such as bulk chemicals, agrochemicals, petrochemicals, polymers, fertilisers and specialty chemicals. India holds the position of the sixth-largest chemical producer globally, ranking third in Asia and making a significant contribution of 7 per cent to the country’s GDP. Ranking as the world’s fourth-largest producer of agrochemicals and the third-largest consumer of polymers after the U.S., Japan and China, India plays a significant role in these global markets. 

With the exception of pharmaceutical products, India stands as the eleventh-largest exporter of chemicals, contributing approximately 15 per cent to the world’s total dyestuff and dye intermediate production, solidifying its position as a major global dye supplier. The industry is much diversified, spanning more than 80,000 commercial products and employs more than 2 million people. Proximity to the Middle East, a major raw material source for petrochemicals, enables India to benefit from economies of scale. It had a market value of USD 178 billion in 2019 and this is anticipated to reach USD 300 billion by 2025 with a CAGR of more than 9 per cent. 

The chemical industry, which the government recognises as being vital to the growth of the Indian economy, is allowed 100 per cent foreign direct investments (FDI) except some hazardous chemicals. The industry is predicted to receive investments worth ₹ 8 lakh crore by 2025. As part of the Union Budget for 2023-24, a budgetary allocation of ₹ 173.45 crore has been designated for the Department of Chemicals and Petrochemicals. To foster bulk drug parks, production linked incentive (PLI) schemes have been announced with a budgetary allocation of ₹ 1,629 crore.
 

Equity Markets and Chemical Stocks

The Indian benchmark indices displayed a lacklustre performance in the first half of 2023, recording modest gains of merely 5 per cent. Various factors, including geopolitical tensions like the Russia-Ukraine war, global uncertainties, concerns about a potential recession, the Federal Reserve’s aggressive stance, and a significant selloff prompted by a surge in 10-year U.S. Treasury yields to a 16-year high, collectively impacted the performance of the global markets. 

On the contrary, domestic indices experienced more than double the gains in the second half of 2023 compared to the first half. The robust rally can be attributed to optimistic growth forecasts, a bolstered economic outlook, and a decisive electoral mandate in the recent elections. Consequently, both the BSE Sensex and Nifty 50 soared to record highs, managing to post gains of 16-17 per cent during the year 2023. While the recent rally benefitted a majority of the sectors, leading to respective stocks reaching new 52-week highs, chemical stocks exhibited significant underperformance. 

A glance at the table containing the 52-week high prices and the latest prices on the BSE of the top 20 chemical companies by market capitalisation reveals a notable downturn. All chemical stocks have experienced a substantial decline from their 52-week high prices, with the aggregate decrease totalling 16.81 per cent. The current scenario raises the question of whether an investor with a risk appetite should contemplate contrarian investing in chemical sector stocks, considering the reduced prices at which these stocks are currently available. Furthermore, it is crucial to assess whether the investment decision will be both sustainable and timely.
 

The Story Behind

The corona virus pandemic triggered a global economic slowdown, impacting a majority of sectors. However, the chemical industry stood out as an exception, displaying remarkable resilience. This was attributed to a sudden and substantial surge in global pharmaceutical needs. Consequently, chemical stocks experienced a robust rally, driven by heightened optimism surrounding the sector. The optimistic outlook was fuelled by both increased global demand and the implementation of the ‘China Plus One’ strategy. It is a strategy where companies diversify their operations beyond China to other countries. This approach aims to identify appealing investment destinations. 

China encountered challenges due to the increased enforcement of stringent environmental laws targeting pollution from its chemical and pharmaceutical companies. Simultaneously, the U.S.- and European businesses faced pressure from institutional investors to reduce their dependence on China. The pandemic-induced disruption of supply chains further contributed to China’s diminishing supremacy in the chemical industry. India found itself in a position to enhance its market share given the prevailing circumstances. With its technical expertise and potential, India could provide global markets with cost-competitive manufacturing. The China Plus One model provided a boost to the EU, Mexico, Taiwan and Vietnam as companies sought alternative investment locations. 

However, the Russia-Ukraine war had a significant impact, particularly with the indefinite shutdown of Russia’s major gas pipeline, exacerbating Western Europe’s gas crisis. Concerns arose that ‘Europe Plus One’ could potentially replace China Plus One as companies considered disinvestment across Europe due to issues such as inadequate gas supply, mandatory targets for reducing electricity consumption, and the subsequent decline in production. In the midst of these circumstances, China, with its capacity for excessive production of chemicals, employed a dumping strategy. This strategy entails exporting goods at a price lower than their market value in the country of origin. 

The availability of goods at a reduced price had a detrimental impact on local manufacturing, leading to intense competition and making it nearly impossible to compete in both domestic and global markets. India’s chemical trade deficit surged to USD 17 billion in the fiscal year 2022-23, a significant contrast to the trade surplus of USD 3 billion recorded in 2020-21. Domestic chemical manufacturing companies, already grappling with challenges arising from the volatility of high raw material prices, faced a significant setback. Companies reported a substantial decline in both revenue and profitability.
 

Financial Performance

When evaluating the financial performance of the top 20 chemical companies by market capitalisation, the overall results for the latest Q2FY24 quarter were disappointing. Numerous companies demonstrated a sequential improvement in their performance during Q2FY24, although there was a notable decline when compared to the figures from Q2FY23. On a year-on-year basis, only three companies including Pidilite Industries Ltd., Navin Fluorine International Ltd. and Aether Industries Ltd. reported growth in revenue. However, on a quarter-on-quarter basis, a greater number of companies reported modest growth. The aggregate decline in revenue amounted to approximately 11 per cent on a year-on-year basis, which showed an improvement, reducing to a 6 per cent decline on a quarter-on-quarter basis. 

A similar trend was observed in the case of operating profit and net profit for companies, where the decline in profit figures showed improvement. The aggregate decline in operating profit improved from 8 per cent to 6 per cent, and the decline in net profit reduced from 21 per cent to 8 per cent on a quarter-onquarter basis compared to year-on-year figures. However, companies are still reporting lower numbers compared to the previous quarters. It is important to note that all the companies are still registering profits, and the situation has not worsened to that extent. It’s evident that companies will need some time to recuperate, and this recovery might occur once the effects of China’s chemical dumping diminish. 

“A contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling.”

— Warren Buffett 

Conclusion

Considering the extensive utilisation of chemicals across pharmaceuticals, agrochemicals, agriculture, petrochemicals, automotive, construction, electronics, food and beverages, textiles, and renewable energy sectors, the chemical industry emerges as a crucial component for the economic development of a country. Furthermore, its GDP share and market standing on the global stage cannot be overlooked. Despite being regarded as multibaggers during the pandemic period, chemical sector stocks have experienced a prolonged downturn due to various domestic and global challenges. Consequently, these stocks are currently available at reduced valuations, proving attractive to investors seeking investment opportunities. 

The contrarian approach, aimed at capitalising on potential reversals, underscores the need to assess the sustainability and timeliness of specific investment assets. Anticipations suggest a positive sentiment shift in the first half of the fiscal year 2025, accompanied by a significant reduction in China’s surplus inventory. Positive developments are observed in the spending on discretionary items like pigments and polymers, whereas textiles and dyes are experiencing a slower recovery. Analysts predict a swifter rebound for bulk chemical companies, particularly those catering to varied end-user markets, once demand gains momentum. 

Following this, a gradual recovery is anticipated in the agrochemical and pharmaceutical sectors. Despite an improvement in the financial performance of chemical companies, challenges persist in enhancing revenue, a situation expected to improve post the cessation of China’s chemical dumping practices. Companies are anticipated to need several more quarters to recover and bolster profitability. Consequently, while investing in chemical companies holds promise, it is advisable for only those investors with a higher risk tolerance and a long-term investment perspective to consider such investments at the present juncture.

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